MASTERCLASS: ETFs – August 2017

The exchange-traded fund (ETF) industry has witnessed record inflows in the first half of 2017, drawing attention to the meteoric rise of passive investment. How are these vehicles structured, what are the best practices in trading them, and what is coming down the product development pipeline? Asset TV brought together experts from portfolio management, legal and market-making perspectives to paint a picture of the state of the ETF industry in this edition of MASTERCLASS.

  • Allison M. Fumai - Partner at Dechert LLP
  • Jillian DelSignore - Head of ETF Distribution at J.P. Morgan Asset Management
  • James Norman - President at Legg Mason/QS Investors
  • Damon Walvoord - Co-Head ETF Desk at Susquehanna International Group

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  • 59 mins 35 secs
Gillian: Welcome to Asset TV, I’m Gillian Kemmerer. The flow from active to passive investing is picking up speed and ETFs are among the greatest beneficiaries of this trend. Today we are here to discuss best practices and latest innovations in Exchange Traded products with four experts who approach the space from a variety of perspectives. Welcome to the latest edition of the ETF Masterclass. Thank you all so much for joining us here today, brill to have you. So let’s get started with some intros. Normally we don’t do this but each of you really touch the ETF industry from a slightly different perspective. So, James, starting with you tell us a little bit about yourself.

James Norman: Great. Thanks. We’ve been involved with ETFs for about a decade or so. And first we started out with multi asset class portfolios allocating to ETFs. And we run both ETF only portfolios as well as ones that combine mutual funds and ETFs. So it’s a great way, have different vehicles to help meet some type of investment objective. So it’s a great vehicle in terms of flexibility. And additionally we just launched our own ETFs about two years ago because we were finding some things we wanted to sort of use ourselves and we didn’t find them in the market, so we launched them.

Gillian: Excellent, Damon.

Damon Walvoord: Sure. At Susquehanna we are a liquidity provider to the ETF space, also known as a market maker. So we’re both providing that liquidity out in the electronic marketplace on the exchanges as well as directly to investors and intermediaries, institutional and retail alike.

Gillian: Wonderful. Allison you’re a legal perspective.

Allison Fumai: Yes. I’m a partner at Dechert’s Legal Group. We focus on the launch of ETFs, novel exemptive relief and other regulatory challenges with respect to the full gamut of ETF products.

Gillian: Excellent, and Jillian, last but not least.

Jillian DelSignore: Yeah, Jillian DelSignore, I am the Head of ETF Distribution at JP Morgan, been with JP Morgan about two years. We entered the ETF business with our first product just over three years ago. I’ve been in the ETF industry for nearly 10 years now.

Gillian: Excellent. So a nice variety of perspectives here on this panel, so I’d like to get started with a little of a look back before we look forward. And Damon, I’m going to start with you, what’s the biggest change that you’ve seen in the ETF industry from the market making perspective?

Damon Walvoord: Sure. Speaking from our side of things, I would say that over the last, since 2003 certainly and really in the last five, six, seven years the increase in the number of products not only available in the market which is obvious, we’re over 2,000 now. But the number of products where real efficient liquidity is available at the secondary level has really increased tremendously. So, you know, five years ago there might have been a 100 or so products where you can get exposures at levels that were actually less than or more efficient than if you were to buy those, if you were to go into the market for those actual underlying exposures themselves. At the ETF level you could obtain those exposures more efficiently. Again, five years ago that was maybe 100, that list of products is now on the order of 500 products across asset classes, across geographies. To us, that’s one of the most remarkable features of the ETF, is that the benefit of the efficiency of the liquidity.

Gillian: Excellent. And you referenced that 2,000 number, the most recent statistics I have from the beginning of last month, 2,024 listings from 113 providers on three exchanges, so an incredibly large industry. Jillian, tell me a little bit about what you’ve seen in the change, I think you said 10 years in the ETF industry.

Jillian DelSignore: They have, we’re coming up on it, absolutely. I think to Damon’s point, I think there’s been obviously a lot of product brought to market. And that for me more so than the number of products that have come to market and certainly there’s been an evolution of that product that has come to market from equities, fixed income, alternatives etc. For me it’s been the new entrants into the market, and the new entrants providing choice. You’re seeing more traditional asset managers, JP Morgan and others entering into the ETF space and bringing with it new levels of expertise and new choice for investors. So that is, I think about as much as I see new product, it’s those new entrants that really have, have been what I’ve noticed in terms of biggest changes in the last couple of years.

Gillian: And I can imagine that increase in choice has made your role increasingly complicated or exciting, depending on how you look at it. Allison, how have you seen things change?

Allison Fumai: That is correct. I think we talked about equity, fixed income. We’ve seen a lot of flow into alternative types of ETFs, which were strategies that were out there that were put into the ETF wrapper. We’ve also seen some developments on the legal front that have allowed for additional types of products to come to market. I think one thing that we are hoping to see now is as the ability to get into the active space becomes easier; the time to get to market is shorter. We’re going to see hopefully more flows there because traditionally we’ve all seen most of the assets in the ETF space within the passive wrappers. But I think the applications that we’ve been seeing in the last few years and the products being filed in the last year or so since they’ve opened up some of the listing requirements has really increased, so more to come on that.

Gillian: Interesting. We’ll definitely be talking more about the active passive. Now, James, what about you, how have you seen things change? Obviously you’ve launched two years ago, you were in mutual funds before that, so.

James Norman: Yes, yeah. I would say the two biggest things that we’ve found is from a client perspective, that first of all interest, there’s a lot of interest and a broad interest from all different types of clients who before wouldn’t even have considered ETFs. And secondly, adoption, we’ve seen an increased adoption. So just as one example, over the last two years, and I think this year will be a third year that this happens, in some of the major wirehouses for example, what we’ve seen is actually higher flows going into ETFs than into mutual funds, so over 50% of the flows going into ETFs. We’re seeing that also that there’s some users that have moved entirely over to ETFs, and that is their primary vehicle for investment. So I think that that interest and adoption cycle has really accelerated. And I think that’s why we’ve seen so much growth.

Gillian: Excellent. Well, let’s talk a little bit about that growth, Jillian.

Jillian DelSignore: Actually I would emphasize, I think that’s a really important point, because as much as we’ve seen product develop and evolve, you’ve seen users develop and evolve. I think if I think back to my earliest days in the ETF industry you had registered investment advisors who had historically always been pretty big users, just the way their businesses were structured. You do see a lot more activity in the wirehouses, independent broker dealers. But even in the institutional space, you know, internally managed pension funds. But you’re starting to see more insurance companies entering and start to think about using ETFs in a variety of different ways. And asset managers themselves start to use ETFs. So there’s just been this evolution across the board in terms of product, entrants as well as usage.

Damon Walvoord: I think that’s a great point. I mean if you trace it back to the beginning, the ETF was created as really as a retail product, as a vehicle for retail investors to get institutional like broad index exposures. Quickly an institutional base of users gravitated to the product as well, primarily for liquidity, quick exposures to broad indexes, countries and the like in the late 90s and the early 2000s. Then you had the retail community again but from the advisor level and it was the RAAs primarily who were building these portfolios of all asset, of all ETFs rather, giving exposures to all asset classes and global type strategies, QS among them was really one of the leaders among others in using all ETF portfolios. And now of course we have the big asset managers who have replicated that same thing, in-house at the broker dealers, they have also created their own, all ETF models. And now with the insurance companies and pensions coming into the space, they’re finding that the ETF wrapper, the vehicle, the instrument can be used in creating these global multi asset portfolios and very efficiently.

Gillian: So we’re not just seeing large inflows but a diversity of where those inflows are coming from. And I’m going to pull up a quick graphic behind me that was recently sourced on Bloomberg by Eric Balchunas, their in-house ETF expert. It shows the shift to passive from active, double speed, this looks at asset growth in ETFs in 2017. We are only looking at each one, this would be a record year end if it were such, but it’s only the first half of the year. So let’s think a little bit about this shift, so called, from active to passive. We’ve already alluded to the possibility of active strategies and passive wrappers and the like. So I’ll start with you, James, again, how do you expect this trend to continue? Do you think that it will become more complicated, will we see more new inflows not necessarily from active to passive, but just new entrants overall? How do you expect it to continue?

James Norman: Yeah. I think there’s a couple of things driving it. First of all I think more and more you’ll see assets flow into ETFs as a vehicle of choice. So I think that’s something we expect to see. That’s when we’re talking to people, that’s the flows we’re seeing from our clients. So I think that’s one big trend. And I think some of the drivers of that are cheap vehicle, it is also tax efficient for those that are taxable investors. But also I think performance is one of them. There’s been a lot of people really questioning how well are active managers, or at least mini active managers have performed over the last five to ten years. So I think that from that perspective I think that’s one of the things driving a lot of flows into ETFs, and index based ETFs in particular. We have also seen that broaden out to smart beta strategies as well. Ones that are sort of the longer ones have been around for decades, like value and momentum and low volatility, but also things that are multifactor ETFs, we’re starting to see the rise of that for example. And then now more and more we’re hearing people interested in investing in active strategies in the ETF vehicle, because they like that vehicle. So I think from all different perspectives we’re seeing more and more money going into ETFs. And it’s going to be broad based in terms of the types of strategies.

Damon Walvoord: Interesting point, some research came out a couple of years ago now, I think it was maybe 2015, the paper I’m referring to. But basically what the study concluded, hypothesized and concluded was that the active versus passive debate in terms of measuring the relative performance of the broad category of the one versus the other really boiled down to low fee versus high fee. And insofar as by and large the active strategies, historically in mutual fund wrappers have been, well, have been (a) in mutual fund wrappers and (b) higher cost than generally your traditionally passive ETFs at lower costs. That really the outperformance over years was as much a function of cost as anything else. And again, you know, you spoke, James, of the benefits of the ETF wrapper and that cost efficiency is a big one because the ETF structure externalizes so many of the costs that in a mutual fund are borne by the fund itself. And that leads toward the higher fee and liquidity of the paper anyhow, the lesser performance.

Gillian: Now, given that we’re in a low volatility environment right now and equity markets, do you see if vol picks up we’ll see more interest in active, or do you think this is secular versus cyclical?

Damon Walvoord: Well, if … and not to hug the point here, but I guess, our view, my view would be that it’s a pendulum and I think this is shared by many. As more and more investors and money go into index type strategies, passive strategies, the stock picker is going to become that much more valuable. When all stocks start moving more and more in unison, all companies and fundamentals and economics obviously don’t move in such unison and therefore for someone to really be able to pinpoint who’s overvalue and who’s undervalued, I think that that, you know, more of those strategies will come back into vogue. It feels like the passive growth still has a long way to run before perhaps we start swinging the other direction. But I don’t think it’s, you know, an inevitable upward and onward trend.

Gillian: Got it. So, Jillian, competitors or can they live harmoniously?

Jillian DelSignore: I think they live harmoniously and really at the end of the day I mean what we’ve seen anecdotally from our clients is that, yes, there are a lot of folks out there that are using just ETFs and in some using just mutual funds, in reality. But more and more are using some combination of both. They are … well, we try to think the most about is what are you trying to achieve? And that’s as we’re thinking with clients and working through due diligence it’s what are you trying to achieve for your end client? And there are tools out there to help you achieve that. And you know, whether it’s using an ETF at the core for low cost efficient exposure and finding those active managers that are actually producing alpha and kind of putting them around the edges, it really is boils down to what are you trying to achieve and let us help you find the tools out there that will efficiently help you do that.

Gillian: Perfect. And, Allison, do you find that among the new launches that are approaching you that they’re also looking or these new measures to try and achieve alpha or new ways to deal with these different wrappers and regulations?

Allison Fumai: The thought is out, especially as you see many of the large asset managers as we have over the last five years come into this space. The majority of their business is truly active in nature. And there are just some strategies that you really cannot put in a passive wrapper. So it goes back to Jillian’s point on choice. It gives the end investor, whoever they may be the choice in an ETF wrapper to look at different strategies that you may not see in a passive wrapper.

Gillian: Got it. And, Damon, when you think about smart beta’s entry into this world, do you feel that it’s really shaken up the active passive debate in some way?

Damon Walvoord: I don’t know if it’s shaken it up. But from the ETF standpoint I view it as almost a stepping … not say a stepping stone but a progression from pure passive, pure index beta, market cap weighted index beta to smart beta or factor type investing. Where they’re trying to kind of distil the investment philosophies and strategies that have been used by asset managers into a rules based methodology, upon which to create, you know, a structure like an ETF that it’s designed to track set index. You know, I think that, I think we’ve seen the growth there in terms of issuers and number of products and types and variety of products, to select from an asset growth. I think that that trend continues. I think the institutional community in particular; the pensions and the perhaps insurance company types seem to be very receptive to these types of strategies. I think that it continues. And I think we see as was alluded I think we see growth continuing down the spectrum of more pure active strategies that are going to find their way into ETF wrappers as well.

Jillian DelSignore: I think what the ETF has really done is just democratize the access. Because if we think back, James mentioned it, Damon mentioned, if you go back, factor based investing has been around for quite some time, just not in an ETF wrapper. And even if we think just about the ETF wrapper going back to the early 2000s, you had dividend ETFs launching, you had value, growth, you mentioned quality, momentum, minimum volatility. And these types of products have seen a lot of inflows over the course of the last couple of years, minimum volatility and dividends specifically. I think when we think about what has been most recently more gravitated towards has been the multifactor. And there continues to be that evolution from sort of equal weighted, and then you move into the single factor, multifactor, soon you move into smart beta fixed income, even in alternative beta. So we kind of see an evolution, but again that ETF really has just democratized access to exposures that have been around for quite some time.

Gillian: Sure. And, James, do you want to weigh in on how smart beta has changed the landscape of the ETF marketplace?

James Norman: Yeah. I think smart beta has been increasingly popular. Well, first of all, the term the ‘smart beta’ I think is a tough term, because it’s sort of like hedge funds. It’s not one particular investment strategy, they are very different. But I think if you’re putting all the sort of rules based approach to have some type of outcome or some type of focus, a way of identifying stocks that have certain characteristics. Smart beta is definitely a popular tool, and increasingly popular because it helps solve problems. And I think at the end of the day that’s why it’s become much more popular. Whether the problem is more money going into market cap weighted indices that tend to have a lot of concentration risk, because they have the biggest weight to the biggest sectors, and if there’s sectors like technology is at the moment, they’re very popular. It’s getting a bigger and bigger weight. We all know these things go in bubbles and bust. So if people are concerned about that, smart beta strategies can help really address those issues, a particular factor exposure or a particular country or a particular sector is really growing a lot. So it’s also prominent, sort of deconcentrating or it’s sort of having a more diversified portfolio.
On the other hand, a lot of the smart beta strategies, whether they’re single factor and increasingly, multifactor, help address a need or a concern in the market, and that’s why the dividend strategies and low vol strategies have become so popular, because over the last couple of years, what is it people have been concerned with? First of all, hard to find income, you can’t find it in fixed income, try to find it in equity. I think it’s one of the reasons it’s driving so many assets to those sort of more risky assets that provide income. Secondly, people are concerned about volatility. Last February, in February 2016, January/February we saw a drop in the market of over 10%. People got nervous. What did people buy? People were afraid of that and they didn’t want to have so much exposure to the downside, they bought low volatility, minimum volatility type of strategies. They want to protect against that downside, especially equity valuations where they are at the moment, which is not cheap. So I think really these are different tools that systematically try to solve a problem. And that’s one of the reasons that’s driving their growth and why they’re going to continue to grow quite rapidly.

Jillian DelSignore: I think you really surface an important point there, you used the word ‘outcome’, right. And the way that I think about it is all of these different products, because we use the term ‘smart beta’ but in reality we’ve talked about minimum volatility, dividends, value, multifactor, they have dramatically different outcomes. And so the importance of due diligence, I think it’s ramped up because you not only need to think about what is that outcome, but how is someone measuring a factor. I measure value maybe differently than somebody else measures value versus quality, versus volatility. And so I think there’s a lot of extra due diligence that should be paid when selecting a factor based strategy, a smart beta strategy. And it’s going to continue to get more important as that specific space in the ETF ecosystem continues to evolve.

Gillian: Sure. With that democratization that you alluded to, increased education is key to keep it that way. Damon, I want to take a moment, since you’re a lone market maker in the group, to give us a little bit of insight into some of the activity and trends that you’ve been seeing.

Damon Walvoord: Sure. I guess the primary thing that comes to mind, because it’s just so prominent and so dominant would be just growth, I mean growth and really in every regard when we talked about the growth in the assets and the growth in the user base. I mean to speak to growth in assets and this has been widely publicized. So many of the viewers are maybe familiar with that, and certainly the people on the panel would be. But in the last 12 months, in the trailing 12 months to date, we’re in July here of 2017, there have been half a trillion dollars into US ETFs, which is a remarkable number considering there was about that much in total in the asset class only a decade ago. Year to date, 2017 is the second biggest year in terms of inflows into ETFs. It’s July and we’re already the second biggest, last year being the biggest. And in particular, I guess, getting a little more granular, one of the areas of interest, although it’s very much across the board, the international ETFs have seen tremendous inflows this year. Speaking of this year, both developed markets, Europe as well as the emerging markets which have had $20 billion into them. In the international space, for the international equity ETFs, this month, rather, June was the second biggest month of inflows, exceeded only by the month before, May of this year. So you get the idea, we could go on and on but our time is limited.

But growth in terms of the assets, the inflows, fixed income disproportionately versus all of the equity side of things. Fixed income has really been a theme where the user, I think importantly here, very driven by the user base, the expansion of the user base and the adoption of ETFs as a common tool, as a financial instrument used by the bond community, by traditional bond fund managers are really now have gravitated towards using ETFs for their exposures. We saw it first in high yield. We’re seeing it this year in a big way in investment grade corporate bond ETFs.

Gillian: And, Allison, coming to you, from your perspective, how have you seen the regulatory environment or appetite change when you think about all of these new types of strategies, whether it’s active in a passive wrapper or smart beta, what’s been some of the changes that you’ve witnessed?

Allison Fumai: Sure. Well, it took quite a while for the SEC to get comfortable with actively managed ETFs. So it’s still been a little slow growth since they’ve come out. But one of the things that people were not aware of was in addition to just getting regulatory relief from the SEC, there’s also listing relief that’s necessary. So you’re talking about the large growth in international ETFs, if you were to come to me a year and a half ago I would have told you, “We’re not going to see a whole lot of international ETFs on the equity side.” Because there were restrictions with respect to what you could put into an international ETF that’s in an active wrapper, because of these listing concerns. That went on for about six years. And the industry fought it and fought it and fought it, and frankly, the big argument was, well, we’re doing it in a passive wrapper. By putting it in an active wrapper why does this make a difference? So about a year and a half ago when they started opening up the landscape to allow active ETFs to come out on a much faster timeframe, they lifted this hurdle with respect to international. So it’ll be really interesting to see as number one, the number of active ETF applications and sponsors that are getting into that active space increases, and it has been over the last few years. There’s growth in the international ETF space as well as this kind of opening up of the regulatory regime as we see more of this, again, going back to the growth in the active space. So I think again while maybe proportion wise the active ETF space is relatively small compared to passive, it hasn’t had as much time and there’s been limitations on it to grow. But now we’re seeing more and more folks take advantage of this ability to get into that space a lot faster and we’ll see a lot more growth in that space.

Gillian: So could you make a blanket statement that we’re seeing tailwinds toward deregulatory pressure or would you say it’s very much on a case by case basis?

Allison Fumai: You know, that’s a great question. And the ETF industry is really kind of scratching their head at this point. Because with the change in the administration, that’s what’s going to make the most here, and we’re still waiting to see where this change to administration, the commissioners that are coming in, even the new chair, the way they think about ETFs. Because some of the concerns that were raised in the ETF front that led to kind of heavy regulation and skepticism around some of these ETF products, may be going away as a result of this administration. So we still need a little more time to tell. They haven’t come out outright and said what their focus is going to be, what they’re going to be looking at and whether they’re going to allow these additional developments in the ETF space. But frankly, we’re all relatively positive and hoping to see more trend in that direction.

Gillian: Okay. And by the time we speak next we may have even more clarity there.

Allison Fumai: That’s exactly right.

Gillian: Jillian, let’s give a little bit of a do’s and don’ts for the advisors that are watching the program. Could you give us an overview of how ETFs trade? And any suggestions you have for best practices there.

Jillian DelSignore: Yeah, absolutely. And I’ll certainly defer to Damon for thoughts on this as well. I think one of the biggest things that we always try to emphasize to advisors that we’re speaking with is don’t think that screen volume equals liquidity, right. Screen volume does not equal liquidity. Liquidity of an ETF is a function of the liquidity of the underlying market. And so there are a lot of resources and tools out there to help advisors really understand what it would feel like to trade in an ETF regardless of the size. So most ETF issuers have capital markets desks that I would encourage advisors to leverage, as part of the due diligence process, you know, we’ve said to own an ETF you have to trade it. And so that T stands for Traded, right, as we like to say. And leveraging the capital markets desk at these issuers to help understand the cost of getting in and out of these products is really important, because we have relationships with folks like Damon who help inform us and can further assist the clients as they are looking to enter and exit their specific ETF positions.

Gillian: Excellent. Damon, do you suggest for example the use of limit orders?

Damon Walvoord: Absolutely, I always tend to start there. You know, don’t use market orders would be if you asked if I had a single piece of advice to use when using ETFs is don’t use market orders. And I suppose you could apply that to equities broadly, but in particular for ETFs. Liquidity is available, the structure does allow for a market maker such as ourself to tap into the underlying portfolio and translate that underlying level liquidity into ETF level liquidity. I’m sure you’ve all heard it. But you have to give us a chance to do that. And if you just blast a market order out into the marketplace, we don’t have that opportunity. What’s great about an ETF is you get the greatest, the strongest trading firms in the world, Susquehanna and others that are market makers. We have global reach. We have the most sophisticated systems and expert traders that are able to tap into all these underlying’s. So not only does it give the access, as we’ve talked about, but it gives access via the most sophisticated trade, you know, trading platforms and infrastructure out there to anyone who has, you know, an online brokerage account and can submit their order. So submit that order by way of a limit, at or around what you see posted on the screen generally is a good starting point. And then you put us and others into competition to put our resources to work to go out and get that underlying liquidity or however we might manage to fill the order back to you. So it’s definitely a big piece of it.

I spoke to, not to ramble on the point; I think I could probably talk all day about the trading and liquidity. There are 2,000 ETFs. By and large all of those ETFs are very usable when done so sensibly. Utilize the issuers on a capital markets desk, they can help. If you are an advisor affiliated with a platform or your trades are going through a broker dealer or your custodian. Those desks and their processes for obtaining liquidity very efficiently have developed and matured so much today that virtually across the board, you’re able to tap into that liquidity in an efficient way. Five years ago, six/eight years ago that may not have been so true. But it certainly is today, we have relationships with virtually all of them as do the other market makers out there. So use those resources. Think about it the way you would, your counsel, your attorney, your accountant. Other specialist types of services that you use in your life or in your business, you rely on the experts to do so, do the same when you’re using ETFs.

Gillian: Okay. So limited orders and due diligence still key, James, what about you?

James Norman: Yeah. I mean I would say that while this is one of the biggest areas we run into in terms of clients not understanding and really evaluating an ETF. They look at how much it’s traded rather than what is the implied liquidity of the underlying holdings. So one of the things we do quickly is just go on and take a look in Bloomberg at the implied liquidity of the underlying basket. And if there’s liquidity there, it doesn’t matter how much that ETF trades, it’s important to be able to understand. And what are the underlying stocks liquidity that make up that ETF? So that’s one of the biggest issues we find, and that’s one of the things I think is the biggest misconceptions by most investors.

Gillian: And timing wise, should they avoid opening and closing bell for example?

Damon Walvoord: By all means. And particular using a market order, so if it’s a Market on Closed order, it’s a market order so my earlier comment would stand. If you’re using a Market on Closed order in a thinly traded ETF, there’s a chance that the other side of that liquidity isn’t found at that moment in time. It’s a single moment in time. On the other hand if you’re submitting an MOC order in a very liquidly heavily traded instrument, there’s a possibility, if not even a reasonable probability that there’s going to be some size of an imbalance on that given day. And if you happen to be on a buyer of a 1,000 shares or a couple of thousand shares, or even a 100 shares on a day where an institution is looking to move a $100 million on the close, you’re going to be subject to the movement that they cause. And so rather than subject yourself to the arbitrariness of what others are doing, by using a limited order at the screens during the trading, you know, during the day trading session you’ll have a lot more control and a predictability of your outcome that way.

Gillian: Excellent. So very good crash course quickly for anyone that’s trading ETFs. Allison, how should new entrants that are watching this asset flow, saying I want to be a part of this, what do they need to consider when putting out some of their new launches?

Allison Fumai: Sure. Obviously they have to consider competitors. So in this … as the assets in ETFs and the number of ETFs grows, we’ve seen the asset classes that are underlying these ETFs grow as well. So if you came to me six, seven, eight years ago, there were a lot of new novel products, let’s say in the emerging markets or maybe even frontier, where you’d be the first to market. And it used to be kind of a common trend, first to market, asset flows increase. Now you’re seeing a lot of those asset classes already in these wrappers. So they have to really consider what space are they going into. As we’ve seen across the board from all new asset managers that are getting into this space and even existing asset managers, what’s the pricing. Because we’ve seen those battles, we’ve seen it in the press as the big guys and the little guys fight to keep it down. I think the good part about opening some of these underlying asset classes, whether it be smart beta or even actives, you’re starting to see those windows of pricing open up, which allows more entrants to really compete in this space. There are new asset … large asset managers in the mutual fund space that are very well known in some of their strategies, that’s a natural inroad for them. And again, now that we’ve opened those gates to the active space to be able to launch those products faster, that’s a natural development there. As for getting the exemptive relief and some of the other relief, it’s fairly quick.

So the question becomes and what we talk to them about and what they talk to, frankly, the other folks in the market, whether it be the market makers or just other sponsors is, “When do we come in? What’s the distribution plan? Like what is our approach with respect to distribution of these ETFs?” Because you can’t just simply enter the market, say, “I have a great idea in an ETF.” Utilize either third parties or someone else to help you and then just expect that the assets are going to grow. You need to have a true distribution plan. And why are they going to come to you instead of say one of the competitors?

Gillian: And, Jillian, I can imagine with the democratization as you’ve alluded to, it must be interesting, appealing to both retail and institutional clients.

Jillian DelSignore: Absolutely, I think, you know, as we think about our distribution of our products and we do have both retail and institutional salesforces to go out there after those unique users, because those unique users have unique needs, and we want to be serving both of those. I think the products that are coming to market, even at times can speak to different users. But we have definitely bifurcated our salesforce in order to go after and speak with those clients in their very specific needs in order to bring them, you know, it’s all the same due diligence, but oftentimes those processes can be a little bit different and certainly have set up the salesforce in order to do so.

Gillian: Excellent.

Damon Walvoord: Piggybacking the sort of the concept of the difference of the constituencies that as an ETF product provider that you serve and as a liquidity provider that we serve as well. You know, most of the comments regarding trading a moment ago catered more toward an advisor or to a retail investor, a user of ETFs. For the institutional users of ETFs I think the important things to keep in mind quite differently are whereas there is quite a bit of secondary level ETF level liquidity available in many ETF products as I mentioned at the beginning of our conversation. The important thing is knowing the relative level of where that ETF liquidity is trading, viz-a-viz the underlying liquidity that we spoke of. Generally speaking the underlying liquidity is the real depth of the pool so to speak. And that should provide the backstop to where you can get your order … your order completed and filled, even if it’s your $100 million order or your $1 billion order which we do periodically see in ETFs. So when sourcing liquidity for those trades, when executing those trades you want to take all the liquidity that’s available at the most efficient levels and that may be in the secondary market up until a point at which point you want to shift gears and be able to tap into the underlying liquidity. So those are some of the things for institutional users like QS, in fact we did some sizable trades earlier this week. And those are the types of conversations and calculations that we’re making in that context.

Gillian: Excellent. Now, James, as advisors incorporate more ETFs into their clients’ portfolios, what information do wholesalers really need to be sure to convey?

James Norman: Right. I think there’s people really need to understand a couple of other things. First of all you need to be able to explain how the vehicle actually works, and what the benefits of it are, because out there in the field if you’re new to ETFs, you’re not sure exactly how it works, what the benefits are, how to maximize the, you know, the trading efficiency and things of that nature. So I think that’s one thing that the whole selling force needs to really understand that well, be able to explain that, articulate it well in an understandable way. Secondly, I think it’s also important to understand, just pulling back and looking under the hood, how does the strategy actually work? What would success look like? When would that particular strategy do well? When might it be more challenged? It’s particularly important for obviously a smart beta and an active strategy. But I think it is very important because we do see a little bit of product proliferation, there’s a lot of strategies out there that sound sort of similar. But when you actually look under the hood they’re a little bit different. I think it’s important to know the differences so that the advisor knows this is what I’m trying to seek for my client, this is the outcome that I’m trying to seek. Is this going to actually reach that outcome most effectively? And can I communicate that to my client? So the wholesaler needs to be able to understand that and communicate that clearly.

Gillian: So you’ve alluded to looking under the hood of some of these investment strategies. So I think we should do just that, and Jillian I'm going to start with you. We have referenced smart beta a few times here. But the fact of the matter is many, or most of the flows to low cost ETFs have gone to market cap indices. So why do you think smart beta has struggled to get a little bit of that traction?

Jillian DelSignore: So I think first of all if we take a step back and again sort of dissect smart beta, right. So if you actually look at the dividend minimum volatility and value and growth products as they are captured under smart beta, they definitely have seen a lot of flow. I mean 2015 and 2016 minimum volatility saw incredible flows. And dividends continued to see incredible flows for the outcome reasons that James talked about. I think what we've seen most recently is multifactor ETFs have been the most recent entrance into the smart beta category if you will. They have been slower in gathering assets, but are gaining a lot of speed. I think a lot of these, they are rules based, but many of them have shorter track records and so as many of them, or ours actually have just started hitting three year track records, you start to see acceleration in that flow. So I think if you take a step back and sort of parse out the smart beta space, certain areas are seeing tremendous flow and others are continuing to grow. Now that's not to say that market cap weighted is not still absolutely dominating in that context. I think there's a bit of momentum there. But we certainly are seeing advisors and institutions start to reevaluate what they're looking at, observing some of the flaws that can come with market cap weighted indexes that James talked about, those concentrations of risk that some folks are looking to avoid. And potentially looking for a better beta, a better core solution, and that's why I think you are starting to see much more momentum and much more traction in things like multifactor ETFs.

Gillian: And, James, you've launched a multifactor ETF, the low vol dividend. So I would imagine you've seen some appetite in the market that would encourage you to release a product such as that.

James Norman: Yeah, absolutely. So there's actually two series that we've launched, one is more that core strategy diversified across countries and sector, and it's diversification based investing. And that's to address some of those concentration risks. Like for example in emerging markets, you're looking to invest in emerging markets between Korea, Taiwan and China you have about 50% of the weight. Do you really want to have 50% of the emerging markets there? And the other 20 plus countries have very, very small weight. So you're probably not capturing the growth opportunity appropriately, and you have a lot of risk in one little area. So to be able to address that type of concentration risk, I think is important to clients, because you have some providers that have launched emerging markets, ex China just to deal with that, it still doesn't fully address the problem I feel. But there's definitely a demand in the marketplace to address those concentration risks. On the other side multifactor outcome orientated. So if you want to, for example, have a low volatility portfolio, one of the issues with looking purely at low volatility that a lot of people become concerned with is the valuation. There's been so many people piling in to low volatility, minimum volatility, stocks looking back historically, they've gotten relatively more expenses in the market, with good reason. People are afraid of losses, so of course they're piling into those types of stocks.

However we've seen really an interest in sort of addressing the evaluation and adding more fundamental type of characteristics, like high sustainable earnings. If a company has low volatility of earnings and also it’s suspected to continue to have low volatility of earnings, you have that screen for things like payout ratios. So people aren't ... companies aren't paying out more than they're actually making, because that's not sustainable, that's when you might see volatility going forward. How can you combine multiple characteristics together to have an outcome, and really be more likely to have that low volatility and also have a cheaper than market portfolio rather than more expensive if you're purely looking at a single factor type of approach?

Damon Walvoord: I think so many people when we talk about these kinds of things, and James to hear you describe it that way, and your comments a moment ago, Jillian. It just makes so much sense. And I think it makes a lot of sense to a lot of people. So you talk about maybe the slow growth, all be it a lot of enthusiasm and a lot of exposure talking about smart beta and its growth and its opportunity. Not so much in terms of the scope of the $500 billion of assets and flows that we're talking about, is a relatively smaller slice going into those smart beta strategies and multifactor strategies broadly. And I think that's just, you put it in the context of history, historically you've had your passive type investors who have said this is how we do things, we just go out and we get index exposures. And there's been your active investors and managers of managers who are trying to select the smartest guys out there to run the active strategies. And there wasn't so much offered in terms of this somewhat of, as I described, kind of middle ground, where you're using so many of the ... in many cases commonsense investment strategies utilized by active managers. You're doing it in a lower cost, more efficient and rules based index methodology that is, you know, that is smart beta.

It's relatively new but I think it has, it’s resonating both with traditional pure vanilla beta investors who are saying, “Maybe there's a better way than just buy them in the market, like let’s try nice, like some of the things that we like. And do that through a low cost smart beta index tool.” And then on the other side, you know, talking to the active community who are maybe disenchanted with paying their managers too much money to get, you know, a not good enough performance but to again, kind of parse out what it is about those managers that they liked and now have a cheaper way of getting it. So, you know, I do believe that that growth is yet to come, it certainly seems that way.

Gillian: And Allison, you deal with a lot of new entrants to the market, do you find that you're seeing a shift toward those multifactor funds in general?

Allison Fumai: Over the last few years we've seen a lot more of the multifactor. And I think one of the other things that comes with the multifactor rather than single factor, the market cap goes to what we're talking about here. There's a lot of education necessary to sell these types of products, get people to understand what James was talking about, about why is this a preferable strategy, or preferable way of running an ETF or a specific strategy to allow them to come in. So I think one of the things we've really been seeing over the last few years is people focused, and sponsors focused on education between the meetings, but also just the materials that are on these websites. I mean one of the great resources of the ETF community is they're really digging into kind of knowledge management resources, whether it's up on our website or handed out during the meetings to get investors to fully understand these more complex multifactored approach to investing rather than going back to your point about kind of more of the plain vanilla ETFs. So as people become more educated, as they understand what's out there, you're going to continue I think to see the flows into them.

Gillian: Now, Jillian, when we think about these smart beta strategies, and the inflows into them, one of the common concerns that you often hear is this idea that are many of these factors priced in? Or if we're looking at a small slice of the investment universe, is there more volatility? So how have they performed compared to the market cap indices?

Jillian DelSignore: So I think it's important, I can speak to the JP Morgan product specifically here. I think what we're focused on is a better risk adjusted return. So I think more so than just performance, and I think James would probably agree with this, and I'm sure can add his own comments. But it's more about what does that ride feel like to the client? With a market cap weighted index, you're getting all of the upside, but you're also getting all of that downside, you are getting the market. I think what we look to achieve, and I think a lot of the strategic beta, or smart beta or factor based products are looking to achieve is that point to point ride for an investor. How do we help an advisor keep his or her client invested during volatile markets? And so it's not so much about pure performance as is it about that risk adjusted experience from point to point. And how can we help protect a little bit more on the downside, when markets start to turn sideways and start to trend down? When in a market cap weighted index you are going to capture the entirety of that and at times as an advisor that can be a challenging conversation with clients. And so hopefully wish smart beta ETFs you can start to be much more deliberate about what is that outcome you're trying to achieve for your client and using that to achieve it.

Gillian: What role does it play in your portfolio and, James, I see you nodding your head, so.

James Norman: Absolutely. This is the exact same conversation we're always having with people. And advisors in particular we find do have that challenge of when markets go down they get a call from their clients, they get a call from their relatives, I get a call from my mother whenever the market goes down. “I should go to cash. I'm 78 I can't afford a loss. I'm not going to have time to recover.” Of course my grandmother lives another 20 years past what my mother is now, so you know. But I think it is a real challenge, because people ... you have to help people help sort of prevent them from doing the wrong thing, from going out of the market when it's hard to be in the market, but when they absolutely should be in the market. Not to make that mistake of buying high and selling low. Really being able to stay in the market, and I think a lot of these tools really do help that, whether it's a multifactor approach that mitigates some of that downside risk because you're not as concentrated. And JP Morgan has some great product in that space. Or whether you're looking for something that is sort of has that downside protection even more, like with a low volatility, high sustainable dividend product. Last year's a great example, the market was down 12%, we were down just over 3%.

That made it easier to have that conversation where the advisor can talk to the client, say, "Hey, listen, the market went down. But one of the ways we're mitigating some of that downside risk is through something like this, it did what it was supposed to do." Now, when the market's going up, it's not going to capture 100% it's going to lag. Maybe it’ll capture70/80% of the upside. But you know what, it's going to be there to help you, just like your fixed income has, same type of thing, that diversified approach is another tool in the toolkit to help have the advisor have that conversation with their clients, keep them in the market. Because as we all know, longer term, that's what you have to do to make money. And this is the big mistake people make, they hold too much cash because they're nervous, or they go to cash and then they don't get back in early enough. So how can you create tools like this? And these tools I think are really effective.

Jillian DelSignore: I think some of the benefits of the multifactor ETFs, you make a good point about not capturing all of the upside. You know, if you think about all the flows that are going into minimum volatility. And look, that minimum volatility, ETFs are a terrific tool. But I think as more and more advisors are looking for something they can hold at the core of a portfolio they want something that's, yeah, it may not capture all of that upside. But they're willing to give a little bit of that up to protect on the downside, so that they're not getting so many of those phone calls from their clients.

Gillian: As we talk about strategic allocations should investors try to time factors?

James Norman: Timing the market is extremely difficult, timing factors is extremely difficult. That being said I think starting at a base of having a diversified exposure to various types of drivers of the market, whether it be country sector or factors, is always helpful because it's hard to predict which one's going to do better than the other. That being said, there are certain time periods, economic environments where you are in the business cycle that might help you predict what you would expect at least to happen going forward. And let me give you one example. We have done some research and some papers on looking at low volatility stocks. One of the things you would expect is after a period of low volatility, especially if it's combined with a lot of liquidity in the market, that usually leads to a time period after that when volatility spikes and there might be a drawdown, especially if liquidity's been drawn. Sounds sort of familiar to this type of environment, but we found historically going back that a period of low volatility is usually followed by a period of higher volatility with drawdown. That might be a good time to have maybe a little bit more of a tilt towards lower volatility type of names. Maybe you'll be giving up some of the upside. But that's when you might expect to have a downside. So same thing, after a big drop in the market, that's when value does well. So if you’ve had a big drop in the market you might want to have a little bit of tilt towards evaluation type of strategy, because that's when you'd expect that to outperform, just like we saw in 2009. So I think a little tilting around the edge can help add value, but you have to be very careful and just use this, and it's a very spicy spice, use very little of it in your food, but it can add a little value.

Damon Walvoord: It's a little outside of my realm but I think it's an interesting point that you make, and the notion of the tools and the toolkit. You know for years in ETFs and otherwise, investors and mangers have had sector tools and country tools and size and style tools, geographical asset class, etc. Now you have these tools where you can decide are we in an environment where value is favored over a dividend strategy and, you know, and on down the line. And I guess some of the multifactor strategies have that built in and kind of do the factor timing for you.

Jillian DelSignore: Absolutely, it’s what is that, what is the investor looking to achieve, right. You can have a multifactor at the core, and actually one of the ways that we're seeing investors, advisors and institutions implement some of these factor based strategies, is to use something like a multifactor at the core and to do exactly what James is talking about around the edges. And if you have an opinion about value, or size, or volatility at any given time, tilting towards those, but knowing you have sort of a core, a little more stable, if you will. And then using these other tools at your disposal to tilt one way or another based on how you feel about markets.

Gillian: Excellent. So we've dove a lot into some of the new innovations in smart beta. But obviously there are even more new products coming to market. And Allison I want to start with you on the non-fully transparent active ETFs coming to market. Can you talk just a little bit about some of the considerations around these vehicles?

Allison Fumai: Sure. So I think it will be some time unfortunately before we do see them come to market. But we see a lot of ideas being developed out there, a lot of exemptive relief that's being discussed with the SEC. It varies, there's different approaches, there's the blind trust approach and there's the proxy basket and similar type basket approaches. And what they're trying to argue is we don't have to show the world our portfolio on a daily basis in order for an ETF to trade efficiently. So matter what the process is, what the arguments of the SEC has been over the last say six years or so, and frankly, even longer. There have been conversations about a non-fully transparent active ETF is we think that the efficiency of the market now, the fact that the arbitrage process exists and is working efficiently, can still exist in a portfolio that's not showing its holdings daily. And there are different approaches that have different types of information that are being provided on a regular basis or a less regular basis. But the staff has not come to terms with that yet. I think one of the biggest issues that we're dealing with is these products are not out there trading, so, for the SEC to get comfortable that we can offer this to the market and have all of these ETF sponsors plus more running in, makes them a little bit nervous. There's also been some folks at the high levels of the SEC that have been fairly skeptical about ETFs.

As we're talking about education, the more I think that the regulators are educated on ETFs generally, the way they trade, what drives them, the way they understand kind of the operations of the ETF. I'm hoping that that plus the asset managers that are behind this approach, that they've been in the market for decades and decades. They know how things trade, they know how the asset management industry works. They can come up with portfolios and talk to market makers like Susquehanna and other APs and the like, to get comfortable that if we gave you x amount of information you'd be willing to trade in the product. And ultimately it's a win, win for everybody, because investors benefit by getting a greater range of choices. Those asset managers that have been hesitant to get into the industry because they're not comfortable, especially on the equity side, showing their secret source and showing their portfolio on a daily basis, will give those investors even more of an opportunity to get exposure to that strategy and really open it up. I think that as the education continues within the industry, as you see assets flow into the industry as the increase in actively managed strategies generally in the fully transparent space increases, I'm hoping that that plus the change in the administration will allow some of these non-fully transparent active ETFs to make their way through. And there's been a lot of comments that have come out of the SEC, rightfully so, because they want to understand the product.

But the good news is those asset managers that are working on these type of products, and more and more are kind of getting on-board the different strategies, they're coming up with the responses that hopefully is making the staff more comfortable with these types of products. So I'm fairly positive that we will see them. But I think more education needs to be had before we see that first one launched.

Damon Walvoord: Yeah, I'd agree with all that. And I think the main obstacle or objection that the SEC has raised has been with respect to liquidity. And kind of putting it in the investors’ perspective it's they want to [inaudible], the SEC, the regulators want to ensure that users of these products, if they were to be made available and approve them in the marketplace for use, that the investors are getting a fair price. And for that to happen, the liquidity community, the market makers have to have a view of what is the value of that security at any given point in time, in order to provide that liquidity around the fair value. And so in order to have a fair value in real time throughout the trading day when investors are going to try and use those products, you need to know, to know it with a high degree of precision, you need to know well, what's inside of that wrapper? And what are those things inside the wrapper worth? So in the case of a US equity ETF, it's very simple, what's in there? Well, it's these 100 stocks. It’s these 500 stocks in the S&P 500 ETF. And what are those 500 stocks worth? Well, from 9:30 in the morning till 4:00 in the afternoon New York time, when ETFs are trading in the US, immediately the US equities are also trading and you have a highly transparent marketplace, and exchange data feeds and everything else to tell you what each one of those 500 stocks are worth at all points throughout the day. And therefore you have a very high degree of certainty of what the ETF is worth. And thereby the ETF ... the liquidity community can be out there posting bids high liquidity and offside liquidity to meet the investor needs and give them that fair outcome, that good price sort of experience.

The concern with the no- transparent is that well, if you don't tell us what's in there, how are you going to know what it's worth? How are the liquidity providers going to know what it's worth, such that they can provide the liquidity fairly? Well, if you look at a significant percentage of existing available ETFs out there, that have been approved and that work quite well by most peoples’ accounts, from any of those, whereas we might know with the transparency what's in them. From any of them we don't know what those things inside of the portfolio are worth during the US trading day. For example, a Hong Kong ETF or emerging market ETF, or many bond markets where there is no really highly transparent real time data feeds of the component bonds in the portfolio. And yet, the ETF liquidity community again, and the market makers have been able to build models to account for that lack of pure transparency and still provide very efficient and reasonable liquidity and fair prices. I think the same stands true and I think the SEC’s kind of hung up on the fact that well, if you don't know what's in there, you're never going to be able to price it. And the proposals that are out there are giving a reasonable degree of information about what it's worth, such that we can price it, all be it not with perfect precision. And there will be a little bit more risk premium built into those liquidity levels. But you look at, you know, your Vietnam ETF and it’s, you know, if you want to launch an actively managed non-transparent US equity strategy, we're going to have a lot more certainty around that price than we do around, you know, Pakistan or Kenya. There isn't a Kenya ETF, but there will be one. There's Nigeria.

Jillian DelSignore: It's just a matter of time, yeah.

James Norman: So I think it will happen, yeah.

Gillian: So we're coming to the end of our discussion. I want to give you each an opportunity to offer some closing remarks on what you think any advisor or institutional investor watching this program really should take away about ETF. So, James, I'm going to start with you, what's the central point?

James Norman: Sure. I think the central points are ETFs are a great tool to use to accomplish client objectives. And at the end of the day when people are working with clients who … I think the two things that are most important right now, are first, understanding what those client objectives are. And then also what are the assumptions, capital market assumptions that advisors every day are trying to figure out what those are in terms of where are returns going to come from, and where risk is going to come from. So when using, I think, ETFs are great tools to help build a portfolio, the asset allocation that can help meet those client objectives. So, for example, to make it more concrete, if someone is in or near retirement, and their biggest objective is not to lose money, they want to participate in that market somewhat but they don't want to lose money. Tilting the portfolio more towards low volatility where things that are more defensively sort of positioned, probably is a good thing to do because the end client will be happier with the outcome if there is a down market. But they're going to still participate on the upside. Whereas if somebody wants a little bit more growth, that portfolio's going to be a little bit different. And ETFs offer great cheap tools that are tax efficient to get that exposure. So I think it's a great tool, especially considering where we are in the market cycle, in the capital market expectations, nobody's expecting to get huge returns out of fixed income particularly at this part of the cycle. Equities also people are concerned with, so if you can get a vehicle that's cheaper and tax efficient and can get you there, that is a great way to actually get that exposure and meet your client objectives.

Gillian: Thank you. Jillian, closing remarks.

Jillian DelSignore: Yeah, I would actually emphasize a lot of what James just said. I think focusing on ETFs as a tool to try to achieve the outcome that your client is looking for, and remaining focused on due diligence. Starting with what you're looking to achieve and then backing into it and leveraging. There are so many resources out there at an advisor’s disposal, not only the issuers and our liquidity providers, but all types of third party resources out there available to try to help advisers make the right decisions for their clients. Because the number of tools as we've talked about many times, is continuing to evolve and it's important that they understand what it is that they're buying, know what you own I think is what I would emphasize. But they're incredible tools, and hopefully they can help their clients achieve the outcome they're looking for.

Gillian: Excellent. So from our two product providers focusing on outcomes and performing that due diligence. Damon, from the market making perspective?

Damon Walvoord: Sure. I think the point I'd make is that there really truly never has been a better time to be an ETF user, an ETF investor than today. I think that only probably continues to grow for the foreseeable future. We talked about the number of products on offer. But in terms of the liquidity and the efficiency, it's really mindboggling from my standpoint and at a risk of getting wonky, which I've been accused of in these types of conversations before, so cut me off before I get there. You know, the ETF structure allows again that you can get an exposure, and at the ... at a minimum you ought to be able, if done thoughtfully using the resources that we talked about before, that variety of investor types have at their disposal, whether it's the issuer capital markets desk or the platform execution desk, or for an institutional investor an ETF broker partner or trading partner. Use those resources and using them properly you're going to get the exposure that you're after, at a level that's reflective of the costs of getting that exposure at worst. And at best and now for 500 or more ETFs you're going to be able to get at least some degree of that exposure at prices that are better than full price, so to speak. So if you're buying a bond portfolio, the bond spread might be 30 or 40 basis points, and if you were to go out and buy all the bonds in your index it might cost you that 30 or 40 BIBs in trading costs to get the exposure. If you use the bond ETF you might be trading across a penny wide spread on a $100 product, you’re going to be trading at a basis point to get, you know, a meaningful amount of liquidity. And the key is knowing again where to get the liquidity at the ETF level and when to shift into the underlying level, and depending on your size will dictate, you know, who you work with in order to make that happen.

Gillian: Excellent. And Allison, last but not least.

Allison Fumai: Numbers can't lie, for over a decade we've seen asset flow into ETFs, increase number of ETFs, so no matter what way you slice it, there's been a demand for ETFs. The increased education out there will allow users who may have not been in the ETF space, or sponsors that may have not been ready to get in, to increasingly get in. We've seen more and more sponsors over the last five years get into this space and do so effectively, just allowing for more optionality at the investor level, which can only be good.

Gillian: Excellent. Well, thank you all so much for taking the time to share a little bit from your perspective on this incredibly fast moving market, and growing market. And we look forward to having you back in the studio soon. And thank you for tuning in. From our studios in New York, I'm Gillian Kemmerer, and this was the ETF Masterclass.